Fed watchers see restaurants testing disinflation

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A Chipotle Mexican Grill Inc. logo in the window of a restaurant in Hollywood, Calif. in 2012. For the first time since 2011, Chipotle is altering menus at its chains nationwide and raising prices one some items by as much as 6 percent. Restaurants are seeing an opportunity to raise prices as Americans pay higher grocery bills. (Patrick T. Fallon / Bloomberg News) - Bulletin

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A Chipotle Mexican Grill Inc. logo in the window of a restaurant in Hollywood, Calif. in 2012. For the first time since 2011, Chipotle is altering menus at its chains nationwide and raising prices one some items by as much as 6 percent. Restaurants are seeing an opportunity to raise prices as Americans pay higher grocery bills. (Patrick T. Fallon / Bloomberg News)2565033

NEW YORK - Restaurants could see an opportunity for additional price increases as Americans encounter more expensive food at grocery stores.

The cost of eating at home rose 1.7 percent in April from a year ago, the largest increase in almost two years, while consumers paid 2.2 percent more at U.S. eateries, according to the Bureau of Labor Statistics’ monthly consumer-price index. Food-at-home inflation has been accelerating, reaching its narrowest gap relative to dining out since June 2012. May data on retail prices will be released Tuesday.

“People who have to predict things like inflation or pricing power should be watching this differential very closely,” said John Manley, chief equity strategist at Wells Fargo Funds Management in New York. That’s because, amid concerns about disinflation, investors and Federal Reserve watchers are looking for signs that companies are able to pass along higher costs to their customers, he said.

While central-bank policymakers have said price pressures are ”contained,” some districts reported rising food costs, particularly for meat and dairy products, according to the June 4 Beige Book business survey. With commodities such as beef and pork now more expensive at grocery stores, restaurant operators may see room to boost prices of certain menu items, Manley said.

McDonald’s, the world’s largest restaurant chain, monitors this relationship because the company has said “your refrigerator is a big competitor,” according to Sara Senatore, a New York-based analyst at Sanford C. Bernstein & Co. As food at grocery stores becomes more expensive, this gives the Oak Brook, Illinois-based operator “a little more breathing room” to make menu changes, she said. “The more that price is a decision factor in dining out, the more people are going to compare it directly to eating at home.”

Amid “more significant increases” in food-at-home inflation recently, McDonald’s is expecting higher commodity costs - particularly for protein - in the second quarter, Peter Bensen, chief financial officer, said on an April 22 conference call. “We watch these indices closely yet are also mindful of cost pressures, not only in 2014, but next year as well, when making our pricing decisions.”

Sales at McDonald’s U.S. locations open at least 13 months fell 1.7 percent in the first quarter, the second consecutive period of declines, based on company data.

The industry is grappling with excess capacity and declines in foot traffic - trends that make operators wary about raising prices at the risk of losing customers. In addition, the primary driver of consumer spending - disposable income growth - hasn’t improved in this lackluster economic recovery, said Larry Miller, founder of MillerPulse.com in Atlanta, a restaurant- industry benchmarking service.

This money - left over after taxes and adjusted for inflation - rose an average of 2.3 percent in January-April from a year ago, compared with an average of 3 percent in the two years before the recession that began in December 2007, based on figures from the Commerce Department.

So even though higher food-at-home inflation should in theory help the dining industry, it also could leave Americans with less money to spend on eating out, Senatore said. “It’s a little bit of a confounding factor for restaurants.”

Amid a backdrop of flat or declining traffic in the past 18 months, restaurants face a “delicate balance” when trying to pass along inflationary input costs, Miller said. Another hurdle: higher labor expenses on the horizon, as states including Massachusetts recently passed minimum-wage increases and there are efforts to boost the federal level.

Still, the desire among executives to pass along input costs has “crept up a little bit” during the last 12 months, Miller said. Operators plan to increase prices by 1.6 percent in the next six months, compared with about 1 percent in the same period a year ago, according to a MillerPulse survey.

For the first time since 2011, Chipotle Mexican Grill Inc. is altering menus at its chains nationwide. Investors have reacted favorably - sending the stock up 15 percent since April 22 - as the Denver-based company rolls out “a pretty healthy increase” of as much as 6 percent to items such as steak burritos, Senatore said.

Chipotle is “seeing little or no resistance” to the higher pricing and “so far it’s going well,” John Hartung, chief financial officer, said June 11 at a conference hosted by William Blair & Co. The cost of beef was 25 percent higher in April for the Mexican-themed chain than in the fourth quarter of 2013, he said.

While it’s still early to gauge how diners react, Senatore maintains an outperform on Chipotle in part because the company has some pricing power. Across-the-board menu changes have backfired in the past, so each chain must tailor its approach, Miller said, adding that many eateries prefer small and frequent tweaks to avoid “sticker shock.”

Consumers also tend to be more accepting of price increases at restaurants - rather than retailers such as clothing stores - because they’re aware of comparable costs at supermarkets, Miller said.

As U.S. employers continue to create more jobs, it increases the likelihood consumers will pay a little more when dining out this year, according to Todd Hooper, a San Francisco- based partner in the private-equity division of A.T. Kearney, a management consulting firm. Amid slow and steady economic growth, there isn’t a “dramatic opportunity to increase prices,” so restaurants employ “everything in their toolkits” to do so, he said.

Such options include showcasing menu items with a higher margin, offering promotions that aren’t as deep, reducing procurement costs or putting less food on the plate, Hooper said. “The environment is very competitive, so at best they have modest room to move prices up in the short term.”

With more restaurants feeling confident they can pass along higher input costs, this will point to the “early stages of inflation,” a trend the Fed also is keen to identify, Manley said. If customers push back against such price increases, however, it would reinforce disinflationary concerns while pressuring operating margins because companies have to absorb these expenses, he said.

As a result, it’s not clear whether rising food prices at grocery stores will break in favor of restaurants, Manley said. “This is a very significant test of their pricing power.”